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What's Next for the Markets

Last Updated Dec 18, 2009 2:04 PM EST

We've come a long way since March 9. On that date, the S&P 500 closed at 676.53 — a 12-year low. Since then, the index has bounced back with a 55 percent gain, a glowing reminder of why you held stocks in the first place. So, where to invest now? Some of the world's savviest investors are recommending what's known as the "quality trade": blue-chip companies with steady earnings and low debt.

The market’s recent rally has been led by some of its riskier components — the low-quality stocks that were punished the worst in the previous bear market. Morgan Stanley’s head of global macro and asset allocation, Henry McVey, calls the current market recovery a “junk rally,” noting that “the securities of the most fragile players ... have performed the best.” As McVey’s colleagues Gerard Minack and Jason Todd note, this pattern is typical. It’s no secret that markets move in cycles, as various styles and sectors take turns leading and lagging. And according to Minack and Todd’s research, “Low quality [stocks] tend to lead an initial recovery rally.”

Historical trends aside, many observers are struck by just how far these former laggards have come in such a short period of time.

GMO chairman Jeremy Grantham, writing in his most recent quarterly letter, believes that the markets are “being silly again,” and goes on to note that in the past six months “risk-taking has come roaring back,” and that the market is now, in his estimation, roughly 25 percent overpriced. And in his most recent Investment Outlook, Pimco founder Bill Gross cautions that “the six-month rally in risk assets is likely at its pinnacle.”

So where does that leave you and your portfolio? As MoneyWatch’s Eric Schurenberg noted recently, a focus on quality stocks seems to be one consensus. Says Grantham, “Quality stocks (high, stable return and low debt) simply look cheap [and] have proven to be the one free lunch. You simply have not had to pay [historically] for the privilege of owning the great safe companies.”

Minack and Todd agree, writing that “the valuation gap [between high-quality and low-quality stocks] is now extreme enough to stanch quality’s underperformance,” and go on to conclude that overweighting quality stocks should result in “handsome outperformance when equity markets see a material pullback in response to a disappointing 2010.”

It’s a compelling and logical argument, burnished by the reputation of Grantham, who correctly identified the stock market’s last two bubbles. But before you rush off to position your portfolio to capitalize on these predictions, consider these questions:

  • What do they know that the market does not? The high-quality blue chip firms these professionals are describing are among the most widely followed (and owned) stocks on Wall Street. It’s entirely possible that past cycles will repeat, and this sector of the market will outperform in the intermediate term as high-quality growth stocks return to their traditional valuation levels. But collectively, millions of professional and individual investors today are saying that these equities are priced just right. As former hedge fund manager Andy Kessler wrote recently in the Wall Street Journal, “In the long run the market is always right. On any given day, your guess is as good as mine.”
  • What if they’re wrong? There’s a saying on Wall Street that being early is the same as being wrong. In making these sorts of bets on sector or style performance, it’s not enough to believe that signs indicate that something should happen; you need to get the timing right as well. An investor who agreed with Alan Greenspan’s assessment that the market was irrationally exuberant in late 1996 would have had to endure nearly three-and-a-half years of a soaring bull market before stock prices finally began to agree. That’s roughly 850 trading days, the vast majority of which told you, day after day and in headline after headline, that you were wrong. That’s a lot of negative feedback. Even worse, you likely would have been watching your friends and neighbors exult in their ignorance as they continued to reap the market’s rewards. As the late economist Charles Kindleberger once said, there is nothing so corrosive to good judgment as watching your neighbor become rich; and, unless you had an iron will, the odds are good that you would have finally capitulated at precisely the wrong moment.
  • Are you prepared for the risk? Any decision to move away from a market portfolio (the total U.S. stock market) — whether to overweight value, growth, large-caps, or small-caps, for example — requires an implicit bet that the market is wrong, and that you know better. Perhaps you do, but maybe you don’t. And if you’re indeed wrong, you’ll face an opportunity cost of unknown dimensions in the form of inferior performance. As costly as the risk of being wrong may be, however, the true penalty may lie in the temptation to “double down” — moving even further from the market portfolio in an attempt to make up for lost returns.

As market bets go, the quality trade is actually one that would benefit broad market indexers if it indeed comes to fruition. These “high quality” stocks are the same ones that dominate indexes designed to track the U.S. stock market, such as the S&P 500 or the Dow Jones Total Stock Market index. But unlike active investors who act upon this prediction — incurring management fees and transaction costs along the way — index investors would reap the rewards of this strategy while paying only 0.2 percent or so in total fees.

Legg Mason’s Michael Mauboussin highlighted this fact in a recent discussion of the so-called quality trade, “You can go down a list of the S&P 50 [the 50 largest firms in the S&P 500], and find a number of these companies. And if they do well, it’ll be harder for active managers to beat the market because the S&P 500 is a market-cap weighted index, and many money managers are underexposed to these kinds of businesses.”

So, ironically, the conditions that allowed fund managers to perform so well against broad market indexes during the recent rally may have also sown the seeds for the market’s future outperformance. In other words, it sounds like the inevitable ebb and flow that has characterized the stock market throughout its history.

In the end, you can choose to try to identify these waves on the horizon, and ride them profitably before they crash on the shore, or you can accept the proposition that doing so profitably over the long term is a difficult endeavor at best, and instead focus on costs, asset allocation, and maximizing your share of the market’s returns for the long run.

You pays your money, you takes your choice.

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